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October 22, 2001
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The rate cut conundrum

Tamal Bandyopadhyay


A cut in time saves nine.

It's already late. The Reserve Bank of India must cut the bank rate without further delay. Since September 11, at least 14 central banks across the globe have cut rates fearing that the US-Afghanistan war may delay economic recovery.

The Federal Reserve of the US has cut rates twice over the last month and nine times this calendar year. The US Fed rate is now pegged at 2.5 per cent and the discount rate 2 per cent -- the lowest since the time of the Kennedy administration in 1962. The Fed is even ready to cut the rate further if it is warranted.

RBI governor Bimal Jalan must cut the rate at least by half a percentage point to 6.5 per cent. It may not drive an economic recovery overnight but will certainly prop up the overall sentiment.

It had cut the rate by half a percentage point each on February 17 and March 2 to bring it down to 7 per cent -- the level of bank rate in April last year. In other words, the two successive cuts in February and March only rolled over the July 2000 move of the RBI when it jacked up the rate by one percentage point to 8 per cent. By keeping the bank rate untouched for the last eight months, RBI has made it out of sync with the global interest rate scenario.

Once the RBI cuts the rate, banks will be forced to take a relook at the deposit rate structure and subsequently revise their lending rates downwards. This is bound to happen as the inflation rate is now less than 4 per cent making the real interest rate very high. The first sign of credit offtake was seen in September and it can only grow if the banks cut their lending rates.

It's true that banks are allowed to lend to corporates at sub-prime lending rate but only a handful of highly rated corporates can take advantage of that.

On the other hand, if the PLR itself goes down following a bank rate cut, corporates across the board will get the benefit.

Finally, the bank rate cut will also trigger lowering of various refinance rates bringing down banks' cost of funds. This will encourage them to lend in certain sector which otherwise would have been given the shrug.

For instance, none of the banks are willing to extend export credit at a lower rate (2 percentage point lower than their PLR as stipulated by RBI last month) since the export refinance rate has remained unchanged (7 per cent).

Once RBI cuts the bank rate, export refinance rate will go down and this will prompt banks to take the plunge.

No cut please, we are Indians

RBI governor Bimal Jalan can't play a Greenspan as India is no US economy. He had cut the bank rate twice in the last quarter of fiscal 2001 but that is not helping the credit offtake. The only beneficiary of the rate cut is the government as it is borrowing cheap.

The Centre has completed 80.9 per cent of its gross borrowing programme for fiscal 2002 in seven months as money has never been so cheap.

The efficacy of bank rate as a monetary tool is lost. Even if RBI cuts the bank rate, there is no guarantee that banks will respond by paring their lending rates as there is no correlation between the bank rate and the lending rates of commercial banks.

In fact, in February this year when RBI cut the bank rate by half a percentage point to 7.5 per cent, the banks kept quiet. It was only when RBI the cut the bank rate for the second time in March, that the State Bank of India took the lead in cutting the lending rate.

The banks are unlikely to cut their lending rates even if the RBI cuts the bank rate as they (the banks) are not in a position to cut the deposits rates which have already reached the historic low. Unless the entire interest rate matrix is realigned, the banks will not be able to pare their deposit rates for fear of flight of deposits.

The concept of prime lending rate (the rate at which the banks lend money to their top rated customers) has lost relevance as banks are now allowed to lend money at below PLR.

Moreover, the best corporate customers have already delinked themselves from the PLR as they have been accessing funds through other routes like bonds and non-convertible debentures at finer rates.

In other words, the bank rate has lost its relevance and a rate cut cannot instill the growth impulse in the economy unless there is a growth in demand.

There is no creation of new capacity in the manufacturing sector and hence the system is saddled with a stagnant pool of liquidity which periodically see a few ripples when the bond market turns volatile.

A cut in interest rates is advocated as it has an impact on the prices of financial assets, especially equities. But that link is not working for two reasons: financial markets, even if liberalised, are far from being developed and even farther from being integrated.

Second, in the financial sector there is a dominance of the public sector. Much of the financial intermediation business is totally dominated by the public sector. To the extent that this is so, the responses one expects from interest rate cuts are not forthcoming.

Sinha may force Jalan to bite the bullet but it is most unlikely to help revive the economy.

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